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Trustees must always distinguish between what is capital and what is income in the management of their trusts since different classes of beneficiaries may benefit from capital compared with income and different taxes apply.

Defining what is capital and what is income sometimes produces a lack of fairness between those beneficiaries who are entitled to the capital and those who are entitled to income. As a consequence the law intervenes and suggests apportionments. The Law Commission was asked to consider some practical difficulties as a result of concerns expressed during the passage of the Trustee Act 2000 through Parliament.

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In its Report 315 released on 7 May 2009 the Commission considered some of the practical problems in making the distinction between capital and income and recommended the abolition of the equitable and statutory rules of apportionment for all new trusts and the introduction of a new rule of classification for tax-exempt corporate demergers.

Corporate receipts only constitute capital for trust purposes if they represent the company’s legal capital – Bouch v. Sprule (1887) LR 12 App Cas 385. This produces an extremely unwelcome anomaly when a company chooses to demerge. In such cases the company may distribute to shareholders a dividend which actually represents a large proportion of value of the company. In the hands of trustees that receipt will constitute income and therefore will only benefit those beneficiaries who are entitled to the income of the trust whilst reducing the capital value of the trust fund.

In a ‘direct demerger’ a company transfers part of its business to a new subsidiary company and distributes the new company’s shares to its own shareholders in the form of a dividend. The practical problem this poses led the court in Sinclair v Lee [1993] Ch 497 to classify shares that are distributed as a result of an ‘indirect demerger’ as capital because in the court’s opinion to classify the shares as income would be ‘absurd’ given the economic effect of the re-organisation. The Law Commission refers to this distinction between direct and indirect demergers as ‘confusing and unprincipled’.

The Law Commission recommended that shares distributed in a tax-exempt demerger should be classified as capital for trust law purposes. This would simplify the position as it would mean that shares received as a result of either a direct or indirect demerger would be capital for trust purposes.

For the sake of fairness, the Commission also recommended that trustees should have a power to make a payment of capital to income beneficiaries to compensate them.

Although, the Commission’s draft Bill was the subject of a consultation by the Ministry of Justice over the summer no draft legislation has yet been presented to parliament.

The facts

Mr Raymond Taube wished to buy a new house and needed to extract funds from a company, Michael Taube Limited, (the company) to do this. A scheme was suggested by his accountant to avoid a charge to income tax by eliminating the purchase by the company of its own shares from family trusts which held the shares by re-organising the share capital and making a distribution.

On 20 April 2000 the trustees of the Bessie Taube Settlement exercised their discretion to appoint an interest in possession to Raymond Taube, the son of the settlor. This was in part done to ensure there would be no charge for IHT and in part it was designed to make the question of whether the special dividend was capital or income a most important question for the trustees in that they would have to account for it to the appropriate beneficiary.

On 25 April 2000, the company passed a resolution which reclassified the shares owned by the trustees into A ordinary shares.

On 26 April 2000, the trustees were paid a dividend of £2,400 per A share which equates to the entire value of the A shares. They treated this receipt as trust capital as a result of taking professional advice.

On 15 January 2002 Mr Raymond Taube signed and submitted his tax return for 5 April 2001. On 25 January 2002 the trust return for the Bessie Taube 1991 Discretionary Settlement for the same year was signed by him as trustee and submitted. The trust return disclosed the following in the additional information box:

“The trustees appointed an interest in possession to Mr Raymond Taube on 20 April 2000. No income was received in the trust in the period from 5 April 2000 to 20 April 2000.

Following a share reorganisation, the trustees received a special dividend of £777,600 equivalent to the current value of their shareholding in Michael Taube Limited on 26 April 2000. Having taking professional advice, the trustees regard the receipt as trust capital which is not available for distribution.”

The tax return for another family settlement, the Raymond Taube 1991 Discretionary Settlement was also submitted to HMRC and contained a similar disclosure. HMRC opened enquiries into both settlements.

After some correspondence HMRC trusts in Nottingham asked Mr Taube’s tax office in Manchester to raise an income tax assessment on him personally which they did for £174,960 on 6 December 2004 which the agents appealed against.

HMRC trusts also sent amended trust tax returns to the trusts on 29 September 2004. The taxpayer’s agents lodged formal notices of appeal against the amended self assessments.

It was common ground in the hearing that the substantive question as to the liability to income tax of both the trustees of the Raymond Taube Trust and Mr Taube himself as life tenant of the Bessie Taube Trust, depended on whether the special dividend was to be treated as capital or income.

If the special dividend is trust income then the Raymond Taube Trust is liable to income tax if it is income falling within s.686 ICTA 1988 (as the schedule F ordinary rate is fully offset by the tax credit on that dividend). As regards Mr Taube personally he is liable to income tax on the special dividend if as a matter of trust law he is entitled to the dividend that was received by the Bessie Taube trust – which will only be the case if the dividend is trust income.

The law

As indicated above, as a general rule, the profits of a company that are distributed by way of a dividend are received by trustees as trust income. If there is an interest in possession trust, such income belongs to the life tenant. Payments made by the company as capital, or which are appropriated to the capital of the company, are capital and belong to the trust as such or to those interested in the trust capital in accordance with Bouch v Sprule (1887) 12 App Cas 385.

The classification of payments made by a company was considered further in Hill v Permanent Trustee Company of New South Wales, Limited [1930] AC 720 in which Lord Russell said that when a limited company makes a distribution it is not concerned with whether the shareholder is a trustee or not. A limited company not in liquidation can make no payment by way of a return of capital to its shareholders except as a step in an authorised reduction of capital. Any other payment must be by way of dividing profits.

He went on to say that any payment out of the profits paid to a trust would belong to the person beneficially entitled to the income of the trust unless there was something to indicate to the contrary in the trust deed. No statement by the company could change its nature in the hands of the trustees.

The situation would be different if the profits were used to provide new shares which are issued and allotted to the shareholders – the fully paid shares would be received by the trustees as capital and not as income.

The Hill decision was approved and applied in the Court of Appeal decision in Re Doughty, Berridge v Doughty [1947] Ch 263.

Hill was also considered in the case of Sinclair v Lee [1993] Ch 497 which was the case where the court was asked to consider the status of fully paid shares in Zeneca Ltd. which were issued to ICI shareholders by way of a dividend declared by ICI plc which was satisfied by the allotment and issue of Zeneca shares. Sir Donald Nicholls decided he was not constrained by binding authority and in the particular case he characterised the ICI transaction as a capital reconstruction and so the shares in Zeneca were to regarded as capital in the trustees’ hands.

The Vice Chancellor did however acknowledge that he was bound by the cases of Hill and Re Doughty if the distribution had been of cash to regard that as an income distribution.

Counsel for the taxpayers argued this and other cases represented an exception from the general rule and that it was therefore possible to argue in a particular case that a distribution was not income but capital by examination of the circumstances of a particular case or the substance of the particular transaction.

He argued that the special dividends were a division of part of the capital value of the Company on a par with a reduction of capital or a purchase of own shares, as a matter of effect, if not of company law. He echoed the comments in Sinclair v Lee that it would be absurd and contrary of the presumed intention of the settlor to treat the receipt as income for trust purposes.

He urged that the tribunal should find it self-evident that the presumed intention of the settlor was that the special dividend should not belong to the life tenant but to the capital beneficiaries.

The result

Roger Berner the Tribunal Judge agreed with Counsel for HMRC that these cases of exception from the general rule were not properly regarded as exceptions but were transactions which the circumstances held to be something other than distributions and so properly treated as capital and not income.

The Tribunal were bound to find the special dividend in this case was trust income unless the substance of the transactions amounted to something other than a distribution. The special dividend was a cash dividend; it was not a capitalisation as in Bouch v Sprule, nor did it have the features of a capitalisation that were present in Sinclair v Lee. There was not increase in the capital of the company analogous to the issue of bonus shares.

The conversion of the ordinary shares of the Trusts into A shares and the effect of the special dividend, upon the future rights attaching to those shares, were not seen as being anything other than a distribution. The argument that the transaction should be treated as equivalent to the purchase by a company of its own shares was rejected as that would have entailed the cancellation of the shares and an elimination of all rights including the rights to the share capital itself.

Practice points

1. Trust law advice was obtained late in the day and this issue was given little thought – the moral of that story is always ask what will be the effect on trustees of any changes proposed to be made to trust assets in good time before any change takes place.

2. Unless and until the Law Commission’s recommendations become law there is clear, binding authority which will treat the distribution of profits from a company as income in the hands of the trustees and therefore in interest in possession trusts this will be regarded as belonging to the person beneficially entitled to the income of the trust and be taxed accordingly.

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Tel: 01962 776442 Email: gill.steel@lawskills.co.ukGill has worked as a consultant to the legal profession for over 21 years
Gill is a compelling seminar and conference speaker both in-house and at public events with a strong gift for making Wills, Probate, Trusts, Tax and Elderly Client topics practical, engaging, authoritative and informative.
She is developing e-learning designs as part of a blend of learning techniques to aid the profession as it moves from a course mindset to more flexible learning.